Collapse of the Enron Corporation - Case Study Example

Name : xxxxxxxxxxx Institution : xxxxxxxxxxx Title : ENRON Corporation Tutor : xxxxxxxxxxx Course : xxxxxxxxxxx @2010 Executive summary This paper looks at the collapse of the Enron Corporation, a giant company trading with energy sources. The company rose in its performance after its Chief Executive Officer, Kenneth Lay, merged with the natural gas pipeline companies and the Internorth. Soon after, the government enacted deregulation in the energy industry and this led the company into selling its energy at higher prices. The new president of the Company, Jeffrey Skilling together with his team of executives started engaging in illegal accounting deals that saw deterioration in the performance of the company until it was declared bankrupt and bought at a fire price by Dynergy. However, this scandal could have been prevented in the right accounting methods were used. This scandal was blamed on various factors such as the government decision to deregulate the energy industry, the policy of mark-to-market that had been adopted by the corporation and also its corporate culture that promoted illegal accounting practices. After the scandal, the government of the United States passed legislations that could ensure that such a scandal does not happen again and also to protect investors from loss of their money. Introduction Enron was among the leading energy and service companies in the world. The company was based in Texas, in the United States of America. The company was involved in various businesses such as wholesale businesses that involved marketing of physical commodities and risk management financial services. The company also conducted retail business where it could offer outsourcing solutions in energy and facility management to customers in the commercial and industrial sectors worldwide. Some of the assets dealt with include Portland general electricity, pipelines and distribution operations. Before the company was declared bankrupt at the end of 2001, it had about 22,000 employees and its products such as natural gas, pulp and paper could release revenue totaling to $101 each year. The companied remained under good performance for a period of six years until end of 2001 when a scandal called Enron Scandal began. This scandal was after a realization that the financial position that was being reported was sustained by significantly institutionalized and well planned accounting fraud. Since then Enron has been known for determined corporate fraud and financial dishonesty. The rise of Enron Enron rose to be successful in 1985 when it Chief Executive Officer, Kenneth Lay, was merged with the natural gas pipeline companies and the Internorth. Then in 1990, he led the company into selling electricity at affordable prices to consumers and this succeeded after the United States passed an Act that deregulated the sale of natural gas. This law enabled the company to sell its electricity at a higher value thus increasing its profits. In 1992, the company had become the largest in selling natural gas in the U.S with earnings from gas totaling to about $122. In 1999, the company created a website known as EnronOnline that enables easier management of contracts. The company was further diversified and added others assets such as gas pipelines, pulp and paper, and electricity plant. It also offered broadband services all over the world. By the year 2000, the company’s stocks were selling at $83.13 and a market capitalization value of over $60 billion. This image gave higher expectations about the future of the company. The Enron Scandal The Enron scandal came to be known in October 2001 and it ended up in bankruptcy of the company. Arthur Andersen, one of the largest audit and accounting firms in the world also experienced dissolution due to its involvement in this scandal. Basically, after the company was established in 1985 by Kenneth Lay as a product of merger with Houston Natural Gas and Internorthm, after some years the company hired Jeffrey Skilling as its president. Skilling formed a team of company executives who used accounting ambiguity, incorrect financial reporting and the Special purpose entities; the company could conceal billions of debts that were incurred from unsuccessful deals and projects. Andrew Fastow was the company’s chief financial officer by then and together with other members of the executive team, they gave misleading information to the company’s management board and the committee in charge of auditing and pressured Anderson not to take the issues seriously (Barreveld 2002). The company shareholders ended up loosing almost 11 billion whne its stock price decreased to less that one dollar at the end of 2001. It is from this time that investigations conducted by the U.S Securities and Exchange Commission began. At the same time, a rival company, Dynergy gave an offer to buy the company at the most discounted price. In December 2001, the company was bought by Dynergy and was declared bankrupt under chapter 11 of the U.S bankruptcy code. With its assets worth $63.4 billion, it became the largest company to be declared bankrupt in the world. This was followed by sentencing of several executives of the company after they were charged in courts of law with various crimes. Causes of Enron’s Downfall Enron’s financial statements were not transparent and could not portray its operations and financial position to the shareholders and financial analysts. It also had a very complex business structure and had to employ unethical practices such as applying accounting limitations to misinterpret its earnings and also to alter its balance sheet and produce a desirable image if its performance. Fox (2003) describes the downfall as a result of accumulated unethical habits and practices that had began several years down the line. The situation run out of control in 2001 and everything had to come to light. The bankruptcy was a consequence of actions of several people including the Chief Executive Officer, Lay, Skilling, Fastow and other members of the executive committee. Ley, being the chair of the corporation, he approved was just approving the actions of Skilling without even bothering about the details of those actions. However, the situation that prevailed in the economy also allowed for such evils to happen. These were factors such as deregulation, mark-to-market accounting and company culture. Role of deregulation in collapse of Enron Deregulation rules were passed by the U.S congress that saw no regulation on trade with energy. Companies such as Enron were therefore able to sell their energy at raised prices. Deregulation is the process that simplifies rules of the government that may be limiting the functioning of the market forces. Deregulation resulted to reduced energy prices and increased prices but on the other hand, it resulted to volatility in the prices of gas. Enron started to offer services of long-term set prices contracts for natural gas, usually at prices that brought long term reduction in split prices. To ensure continued delivery of these contacts and prevent changes in the split process, Enron invested in long term arrangement for permanent prices with producers and involved other financial derivative such as swaps, forwards and future contracts. The company also adopted the use of special purpose entities to finance some of its numerous transactions. It was therefore surviving under the advantages of deregulation (Markham 2006). Deregulation may not be wise move in the energy sector. Other market sectors in U.S can work effectively as free markets but it is difficult with electricity. In the previous years, regulation was working where there is enough supply and prices are fair because it considered both peak capacity prices and it prohibited manipulation of prices and extra profits. Where the market is deregulated, the utilities and traders turn out to be the targets of the traders. Following the arguments of neoclassical economists, deregulation should result in innovativeness, increased reliability, and reduced prices. However, it has various drawbacks. In California, deregulation aimed at reducing prices by 30 percent and increased reliability; instead, the consumers experienced a rise in the wholesale prices and collapse of market reliability (Derthick, Quirk, & Brookings Institution 2005). It resulted in a very complex market situation where traders such as Enron could deliberately manipulate the supply and the prices and escape from scrutiny thereby fleecing the consumers. Mark-to-market accounting in collapse of Enron Mark-to-market accounting is the process of accounting for the value of an asset or a liability according to the prevailing market prices of the asset or the liability at that moment, or another value that is assessed as fair. This accounting has been accepted in the United States and is incorporated in the U.S generally Accepted Accounting Principles. The principles of mark-on-market accounting can also be applied to change the balance sheet values frequently as per the changes in the market place. In Enron Corporation, mark-to-market accounting was a little bit straight forward. Earlier, the company gave a list of the definite cost incurred in supplying gas and the exact profits received after it is sold. Skilling citing that it would indicate the real economic value of the corporation put the idea of mark-to-market accounting forward. It therefore became the first non-financial company to employ the method in accounting for its complicated long-tem contracts system (United States Congress 2009). According to the principles of mark-to-market accounting, once a long-term accounting has been signed, the estimates for income are estimated based on the current value of the future cash flow. In most cases, it is difficult to decide on the viability of these contracts and other costs associated with them. Therefore, in efforts to try to match the profits and the cash, so many discrepancies occurred and the investors had to be given false reports. This was a case of accelerating their income and it therefore required the company to keep making more deals that will indicate a rise in income level. Initially they could record the earnings from company’s projects but in future, since there was no profit to include, they had to include income from some additional projects so that the company could indicate growth that would pleas the shareholders. With the awareness of the shortfalls of mark-to-market accounting principles, the U.S Securities and Exchange Commission commend its use in Enron on its future trade with natural gas which was later expanded to other commodities. The deals it engaged in using these principles therefore ended the company in loss. Enron’s company culture According to Sterling (2002), the collapse of Enron was not by accident but a consequence of greed and fraudulent actions that were facilitated by its corporate culture. Instead of focusing on creation of the actual value, the management concentrated on maintaining the good appearance of that value and this led them to raise the stock values. This was worsened by the competitive culture that followed where it could reward any better results. Most of the company’s department started to replace their employees making those left to struggle for opportunities to prove their continued employment. While the internal environment of the company remained challenged, its frontage was the opposite. The company influenced political links with the Bush and Clinton’s government and also on Wall Street so that they could receive special treatment. This association created a legitimate environment for the company to practice its fraudulent activities. In such a context, the poor accounting practices that were going on in the company were promoted by the entire management culture that prevailed in the company (Milhaupt, & Pistor 2008). How the Enron scandal could have been prevented There are various things that could have been done, or measures put in place to prevent the scandal that happened in Enron. However, for this to happen, the management team could have been well equipped and ready to embrace to measures. One important thing that could have been done is to conduct continuous auditing. Continuous auditing could have detected the problems early enough and this would have called for an early action. According to Marnet (2008), continuous auditing could give reports simultaneously with the events that are producing the identified results. It can also have an online process that indicates transactions that re taking place at the same time comparing them with the expected results. Any inconsistency can therefore produce a signal that cannot be ignored by the managers and the auditors. The financial transactions that were taking place at Enron were very abnormal such that they could not be ignored after they are detected in such a system. For example, several of their minor entities were not in line with those of the competitors and this could have been easily detected. Another thing that could have been adopted at Enron is the accounting rules for materiality. This is an auditing and accounting concept that relates to the significance of a transaction, the amount, or the discrepancy. Under these rules, auditing and [reparation of financial accounts is done in accordance with a stated financial reporting framework. In this case, assessment will be done based on professional judgment. These rules can also be altered to allow for both qualitative and quantitative measures of materiality where the changes in the corporation are not being monitored by any other body (Knapp 2008). If these measures would have been used in Enron, the main issues could have been avoided. Involvement of the Board of Directors in assessment of the books of accounting could have been more that it was. The board members were not very keen on how the off-books were created in the company and did not take any obligation in monitoring entities after they had been approved. They therefore did not play their role of representing the company shareholders. They attention could have ensured close monitoring of the books and this could have prevented discrepancies. Lessons learned from Enron disaster The collapse of the giant company left the government and other corporations with lessons to learn from. One lesson that should have been learnt is the need for strict follow up of the corporate governance rules. In most cases, the board of directors and the shareholders focus on the economic results of the corporation forgetting other things. This then forces the management to try all means that can bring better results to the organization. This includes illegal and inconsistent means as long as the company records increased returns. This happens where the rules of corporate governance are not well followed and the management is struggling to please the shareholders. The shareholders of other corporations should therefore learn to keep checking on how effective the management is in applying the rules of corporate governance. They should just not be happy when receiving better returns without caring how the results are being attained. This is very important for long term goals of the corporation. Another lesson that the government could learn is the disadvantage of deregulation. Deregulation causes the prices to be low to the consumers and this raises the demand. This can have negative impacts on the general economy of a country. Sometimes it affects companies that were used to providing certain goods or services since they are abruptly caught by competition from other firms. To cope with this competition and to mete the increased demand, the product quality gets degraded. Degrading a certain industry ushers in competitors and this lacks a guarantee that the quality offered by those competing firms is of quality. When some firms cannot stand this competition, they may start employing illegal means so as to maintain their productivity. It is therefore very important to consider the likely impact before the government announces deregulation on a certain industry (Bauer 2009). Another lesson to learn is that in most cases where a company is making large sums of money and at the same time there is a conflict of interest; there is likeliness of fraud and corruption. Where those who are supposed to inspect the net worth of a corporation are making profitable income out of their inspection work, there may be some corruption taking place. According to Bierman (2008), a corrupt company heavily pays its lawyers and the accountants so that they can cover up their illegal activities. This may result to the manipulation of the accounting activities for the favour of the company thus compromising the integrity of the lawyers and the accountants. Such moves should create suspicion among the shareholders and should call for investigations. Those are signs of fishy deals going on in the company and they should apply in any other company. It is a lesson to the shareholders. Another lesson is that a company cannot just be governed by passing of rules without adjusting the culture. The management concentrated on those laws that could see increased returns for the company and no adjustment on the corporate culture that will promote such returns. At Enron, since the focus was only on the returns, the culture made some of the employees to appear unproductive and they were being replaced on yearly basis. Those left had to struggle for every opportunity to prove their hard work. This happened because of the company’s culture that looked at returns and not the prevailing conditions (Rapoport, & Dharan 2004). Another lesson to the investors is that never to invest in companies whose financial statements looks very complex such that one cannot understand them. This was the case in Enron. They complicated their financial statements so that they can reflect good returns but there was no good income. They had to fake some values and include other unrealistic projects so that their books can indicate a well performing organization. It is therefore important for investors to understand clearly the performance of a corporation before investing in it. Generally, the collapse of Enron, such a giant company should been a source of lessons to the investors, the management of other corporations and the government. This is because each of them played a part in the scandal. Legislation that has been passed in the USA to prevent this from happening again The government of the United States passed may legislations in response to the Enron scandal, which were aimed at preventing another scandal of that kind. One of these legislations is the Sarbanes-Oxley Act, which was enacted in July 2002 following the Enron scandal. This act is also known as the Public company accounting reform and investor protection act. This act set new and advanced rules for all the public corporations in the United States, their boards of management and also the accounting firms (Holt 2006). The act was named after its Paul Sarbanes who was also its sponsor. This act is made up of eleven sections, which include extra responsibilities to the corporate boards and criminal penalties to accounting irregularities. The act also requires the Securities and Exchange Commission to devise rules that comply with the new laws stated in the act. Basically, it aims at protecting corporations so that shareholders do not continue losing millions of money (Plette 2008). The other legislation that was passed was the McCain–Feingold Act that addressed the issues of use of non federal money in funding the campaigns (Cosmus 2002). Enron had close links with President Bush and he benefited from them during his campaigns. This is the reason as to why evil and illegal acts proliferated in the corporation without any question. Conclusion The performance of Enron Corporation was so good initially and this attracted so many investors. This was even made better with its merger with natural gas pipeline companies and the Internorth. However, its problems started when Skilling was appointed as the new president. He started illegal accounting deals that gave the shareholders an encouraging value but on inside, things were in the opposite. This continued until things got out of hand and the company was declared bankrupt. This was however a preventable incidence if the right measures had been put in place. This scandal was too big in US and it left a lesson for many people to learn from. It was a lesson to investors, the government and the board of directors since they all played a part. Nevertheless, it led to several reforms that would help in preventing such an occurrence in the future of US economy. Bibliography Milhaupt, C., & Pistor, K., 2008, Law and capitalism: what corporate crises reveal about legal systems and economic development around the world, University of Chicago Press, Chicago. Markham, J., 2006, Financial history of modern United States corporate scandals, M.E. Sharpe, New York. Bauer, A., 2009, The Enron Scandal and the Sarbanes-Oxley-Act, GRIN Verlag, New York. Sterling, T., 2002. The Enron scandal, Nova Publishers, Tokyo. Cosmus, M., 2002, The McCain-Feingold campaign reform act: model bipartisan legislation, St. Lawrence University, Canton. Holt, M.,2006, The Sarbanes-Oxley Act: overview and implementation procedures, Butterworth-Heinemann, London. Plette, T., 2008, The Sarbanes-Oxley Act: implementation, significance, and impact, Nova Publishers, Tokyo. Rapoport, N., & Dharan, B., 2004, Enron: corporate fiascos and their implications, Foundation Press, New York. United States. Congress, 2009, Mark-to-market accounting: practices and implications : hearing before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises of the Committee on Financial Services, U.S. G.P.O. publishers. Bierman, H., 2008, Accounting/finance lessons of Enron: a case study, World Scientific, Boston. Fox, L., 2003, Enron: the rise and fall, John Wiley and Sons,New York. Derthick, M., Quirk, P., & Brookings Institution, 2005,The politics of deregulation, Brookings Institution Press, Washington, D.C. Marnet, O., 2008, Behaviour and Rationality in Corporate Governance, Routledge, Boston. Knapp, M., 2008, Contemporary Auditing: Real Issues and Cases, Cengage Learning, London. Barreveld, D., 2002, The Enron collapse: creative accounting, wrong economics or criminal acts? : A look into the root causes of the largest bankruptcy in U.S. history, Sage publications, London. Read More